Derivatives are financial contracts between two or more parties that derive their value from an underlying asset, group of assets, or benchmark. They are used by traders to access specific markets and trade different assets, and are considered a form of advanced investing. Derivatives can be used to either mitigate risk (hedging) or assume risk with the expectation of commensurate reward (speculation) .
Derivatives can be used to trade any number of assets and carry their own risks. Prices for derivatives derive from fluctuations in the underlying asset. Derivatives are usually leveraged instruments, which increases their potential risks and rewards. Common types of derivatives include futures contracts, forwards, options, and swaps.
Derivatives can be bought or sold over-the-counter (OTC) or on an exchange. OTC derivatives are contracts that are made privately between parties, while exchange-traded derivatives are standardized contracts that are traded on an organized exchange.
Derivatives are used for a number of purposes including risk management, hedging, arbitrage between markets, and speculation. Financial derivatives enable parties to trade specific financial risks (such as interest rate risk, currency, equity and commodity price risk, and credit risk, etc.) to other entities who are more willing, or better suited, to take or manage these risks.
Derivatives have become popular because they are based on the monetary value of an asset, allowing traders to take both long and short positions on an asset such as a stock, letting them bet whether a share price will rise or fall in the future. However, derivatives are complex financial securities that carry their own risks, including market risk, liquidity risk, and leverage risk. It is important for traders to fully understand derivatives markets and the different types of derivatives and derivative products that are available before trading them.
